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Overlay

Overlay is an idea from the hedge fund world, and describes how some managers use two or more trading strategies, layering one on top of the other.

Q. So, this is a big idea in the hedge fund world. Tell us about it.

A. It describes layering one trade or trading strategy on top of another, in order to put a different risk or return twist on the underlying strategy. Imagine a manager who is long US private equity and likes his positions, but is very worried about the US dollar risk (who isn’t?). So they may stick with the PE portfolio, but add a currency overlay by buying, for example, a bunch of Swiss franc ETFs.

Q. OK, that’s very interesting. But it seems like people also use the term just to refer to the overall economic environment.

A. Right. Colloquially, “overlay” is used to refer to the general background economic environment in which traders and hedge funds are operating. A global macro strategist will come in here and talk to you about “the overlay”. Of course, that’s because inside a fund, that macro point of view would be implemented through some sort of trading strategy.

Q. And how do you see the use of “overlays” changing right now?

A. There’s always a trend du jour. Early on, “overlay” usually referred to strategies to address currency risks, as we described a second ago. Then people started talking about “importing alpha” to a beta-based strategy, often by a total return swap. But today what you’re seeing is some large allocators, maybe family offices, putting their own overlays on top of basic alternative strategies that they can access for lower fees than the traditional 2/20. They are creating basic style buckets of investments, through ETFs, mutual funds, or just lower fee hedge and PE funds… and then adjust total risks and returns by implementing their own “overlay” strategies.

Q. So, essentially, recapturing some of the 2/20 by doing some of the work themselves?

A. Right, some of these offices are building up their own internal systems to monitor and manage risk across the various alternative strategies they invest in, and then putting on their own “overlays” at the family office level. Sort of like an internal fund of funds, but at lower total costs.

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